JANET YELLEN: The Fed might need to temporarily run a 'high-pressure economy'

U.S.
Federal Reserve Chair Janet Yellen testifies on the economy
before the Joint Economic Committee on Capitol Hill in
WashingtonReuters/Jonathan
Ernst

(Reuters) - The Federal Reserve may need to run a "high-pressure"
economy in order to reverse damage from the crisis that depressed
output, sidelined workers and risks becoming a permanent scar,
Fed Chair Janet Yellen said in a broad review of where the
recovery may still fall short.

Though not addressing interest rates or immediate policy concerns
directly, Yellen's lunch address on Friday to a conference of
policymakers and top academics laid out the deepening concern at
the Fed that U.S. economic potential is slipping - and may need
aggressive steps to rebuild it.

The question, Yellen said, is whether that damage can be undone
"by temporarily running a 'high-pressure economy,' with robust
aggregate demand and a tight labor market. One can certainly
identify plausible ways in which this might occur."

"Increased business sales would almost certainly raise the
productive capacity of the economy by encouraging additional
capital spending, especially if accompanied by reduced
uncertainty about future prospects," Yellen said. "In addition, a
tight labor market might draw in potential workers who would
otherwise sit on the sidelines and encourage job-to-job
transitions that could also lead to more efficient - and, hence,
more productive - job matches. Finally, albeit more
speculatively, strong demand could potentially yield significant
productivity."

U.S. stocks posted further gains after Yellen's remarks, while
the dollar dropped and Treasuries rose, pushing yields on the
2-year note to session lows.

Her remarks, while pointing largely to research she feels needs
to be done, nevertheless add an important voice to a debate that
is intensifying within the Fed over whether the economy is close
enough to normal to need steady rate increases, or whether it
remains subpar and scarred.

That could figure importantly in coming debates over rate policy,
and over whether support is building at the Fed to risk letting
inflation move above its 2 percent target in order to employ more
workers and perhaps encourage more investment.

From weak inflation to the effect of low interest rates on
spending, little in the economy has been acting as the Fed
expected.

Yellen said it may be the case that the crisis has done such
permanent damage that fiscal and monetary officials will have to
retool how they approach their jobs. For central bankers, that
would mean keeping a broader set of less conventional tools at
the ready, and using them more quickly in a new downturn. The
aim, she said, would be to avoid further scarring.

"This post-crisis experience suggests that changes in aggregate
demand may have an appreciable, persistent effect on aggregate
supply - that is, on potential output," Yellen said.

"If strong economic conditions can partially reverse supply-side
damage after it has occurred, then policymakers may want to aim
at being more accommodative during recoveries than would be
called for under the traditional view that supply is largely
independent of demand," Yellen said. It would "make it even more
important for policymakers to act quickly and aggressively in
response to a recession, because doing so would help to reduce
the depth and persistence of the downturn."

With public expectations about inflation so hard to budge, Yellen
said that tools like forward guidance, "may be needed again in
the future, given the likelihood that the global economy may
continue to experience historically low interest rates, thereby
making it unlikely that reductions in short-term interest rates
alone would be an adequate response to a future recession."